Co-founders are often friends or colleagues who decide to take on the challenge of starting a business together (even the Peak partners are friends from their law school days). It’s easy to think that building a company will strengthen a relationship, but that isn’t always the case. So what happens when a co-founder leaves or is asked to leave by the other co-founder(s)? The short answer is, of course, it depends.
How Much Was Built?
How you handle a co-founder’s departure from the company depends in large part on where the business is in its life cycle. If all you’ve done is share some ideas around a couple of drinks, then there’s a good chance the company isn’t yet formed. As a result, there were no shares issued, no agreements entered into, and probably no revenue to speak of. There’s a chance the co-founders could simply go their separate ways without any formal separation documents.
But what if the co-founders were formal shareholders in their company? What if they were close to unleashing an MVP on the marketplace, or speaking to investors who really liked the dynamic of the team? Here is a general rule to use as a guideline: the more money there is at stake, the more exposure there is to the business when a significant member of the team leaves.
What Agreements were in Place?
Written agreements certainly don’t solve all of the problems connected with a co-founder’s departure, but it’s a really good start. For example, did the co-founder sign an invention assignment which captured any intellectual property (IP) they might have worked on? Without having assigned all of their work product to the company beforehand, there is a risk that a co-founder who is also a developer takes the IP with them when they leave.
If the co-founder is also already a shareholder in the company, then the remaining co-founders are left with some choices: let the leaving co-founder keep their shares, or buy the shares back. There are a few pros and cons of each option. If you let a co-founder keep their shares, then you have someone on your cap table who no longer contributes to the value of the company. This could be a red flag for potential investors, and also create resentment among the remaining founders because in the event there is an exit, the ex-founder will have received a windfall for comparably little effort. The upside is that the exiting co-founder is less likely to cause problems for the company by suing or disparaging the business or other co-founders (doing so would only injure their own stake in the company).
Buying back the shares presents its own set of challenges. In many cases, the company will have to pay fair market value (FMV) for the shares. Depending on the FMV of a share, that could be a very expensive buy-out. In the event the company is able to buy back the shares, there are several other documents the remaining co-founders should request from the leaving co-founder to make sure there is as little risk to the company as possible. Buying back shares from a former co-founder will help redistribute the shares more fairly to people who are still involved in running the company.
In some cases, the remaining co-founders may want to by back the leaving co-founder’s shares but do not have a right to do so. If the leaving co-founder was issued their shares outright or if any vesting provisions have expired and the company has not reserved the right to claw back the shares, then the leaving co-founder must be persuaded to sell. This leaves the remaining co-founders in the unenviable position of having to negotiate with substantially reduced bargaining power.
An Ounce of Prevention…
Having a co-founder leave your company certainly creates headaches, but is also something we consider to be “fixable”, provided the leaving co-founder is willing to cooperate to a certain extent. As with most things, preventing the problems in the first place is a lot less uncomfortable (not to mention cheaper) than fixing them after things go wrong. Talk to an attorney early enough in the process of starting your company so it feels less like overcorrecting and more like being good stewards of a valuable enterprise. Attorneys who work in the startup space know that part of their job is to serve as an advisor to not only the company but also each of the founders. He or she can make recommendations that can go a long way in making sure that co-founders who leave for other opportunities don’t take the whole company with them.
Bob Baker is a founding partner of Peak Corporate Counsel. He has worked with numerous founders on a variety of issues specific to startups. When he’s not advising innovators, he can be found at networking events, playing rugby, or hiking with his kids.
This article is for informational purposes only, and may not be considered legal advice.